Evaluating
the performance of your company
By Ravi Mahendra
Performance ratios can be a useful tool with which to judge how
listed companies are doing but they should be used with care, says
our columnist.
My previous article concentrated on profitability as well as liquidity
measures of appraising performance. Today we will focus on:
*Gearing or long term
solvency measures
*Management efficiency
measures
*Investors' measures
Gearing
or long term
solvency measure
This measure looks at the capital structure of the organisation
and also deals with the long-term stability of the organisation.
It is calculated as: Debt Capital/ Total Capital
Total
capital comprises of Equity Capital (Shareholders’ Funds)
and Debt Capital (Borrowed Funds). The idea behind the measure is
that the stability of the business reduces when the debt component
in the capital structure increases significantly. When a company
has high levels of debt in its capital structure it becomes known
as highly geared and faces the risk of being unable to service its
interest as well as debt liabilities as they fall due. The idea
therefore is that too high gearing is bad.
Management
Efficiency Measures
A number of ratios can be used to measure the efficiency of the
management of the organisation and we would focus on two, which
are:
*Stock Turnover Days
*Debtors' Turnover Days
Stock Turnover Days
This
is a useful measure for a manufacturing organisation, which has
high levels of inventory. It basically measures the time on average
an item of stock stays in the business without moving. It is measured
as:
Stocks/ Cost Of Sales
*
365
Even though it is an average measure it is common sense that the
longer the items of inventory stay in the business without moving
the higher the inefficiency of the management is.
This measure too has to be used with care since the stock turnover
for an Auto Dealer such as United Motors can tend to be different
from that of a Supermarket Chain such as Food City.
Debtors'
Turnover Days
This is a measure of the number of days it takes for debtors on
average to pay the organisation. It can be calculated as:
Debtors/ Sales * 365
The days so calculated can be compared with the credit period allowed
by the firm as well as the general debtors' settlement period of
the industry.
Investors'
Measures
As for measuring return from an investor's point of view
the following can be useful.
*Earnings Per Share
*Price Earnings multiple
Earnings
Per share
This can be calculated as: Earnings/No. of shares.
Earnings would be profit after tax. EPS is often provided in annual
reports and it can be compared over a period of time as well as
with other firms. Growth in EPS is an indicator of the growth of
the company.
Price Earnings
Multiple
(PE Multiple)
This is a measure of the number of times the current share price
is higher than the earnings per share. It indicates the level of
confidence that investors have in the firm. It can be calculated
as:
Share
Price / Earnings
Per Share
A high PE multiple will tell us that investors have a high level
of faith on the future of the firm.
Limitations Of Ratio AnalysisThere are a number of limitations in
using ratios. The accounting policies of companies tend to vary
and comparisons can be difficult to make. Ratios will be inaccurate
if accounts are manipulated. Ratios will have to be used carefully
since their validity may vary with the industry.
One
should not therefore jump to the conclusion that ratio analysis
is the ultimate performance measurement tool.
(In
the next article in this series, the author will look into trend
analysis and other sources of non-financial performance information,
which can be useful for the small investor.) |
